ACCOUNTING FOR SERVICES

RECORDING PROCESS
1. Journalize

FINANCIAL STATEMENTS (IN ORDER)

1. Income statement

General Journal
Date
Account title and explanation

2.

Account Ref.

Debit

Journal page
Credit

2.

Post to ledger
Liabilities + Equity
Cr (-)

Dr (-)

Cr (+)

3.

Retained Earnings
Ex pense / Div idend
Dr (+)

Rev enue

Cr (-)

Dr (-)

Cr (+)

Income Statement
Dr (-)

Cr (+)

Account title
Date
Explanation

3.

Account title

Prepare trial balance

ADJUSTING ACCOUNTS
1. Adjusting entries:

2.

Journal Ref.

Debit

Credit

Account no.
Balance
Debit

4.

Account title
Asset
Liabilities
Equity
Share capital - ordinary
Retained earnings, start
Dividends
Revenue
Expense

Debit

Credit

Statement of financial position (Balance sheet)

Assets
Fixed asset
Less: Accumulated Depn - fixed asset
Cash, end
Total assets
Equity
Share capital ordinary
Retained earnings, end
Liabilities
Total equity and liabilities

Credit

DEFERRAL
a. Prepaid expense - paid, not incurred
Increase (dr.) expense, decrease (cr.) asset / contra-asset (up)
E.g. supplies, insurance, depreciation
b. Unearned revenue - paid, not performed
Decrease (dr.) liability, increase (cr.) revenue
ACCRUAL
c. Accrued revenue - performed, not paid
Increase (dr.) asset, increase (cr.) revenue
d. Accrued expense - incurred, not paid
Increase (dr.) expense, increase (cr.) liability
E.g. interest, salaries and wages

Prepare adjusted trial balance

Retained earnings statement

Retained earnings, start

Add: Net income
Less: Dividends
Retained earnings, end

Balance Sheet
Assets
Dr (+)

Revenue
Less: Expense
Net income / loss

Statement of cash flows

Operations
Receipts
Less: Accounts payable, paid
Investments
Sale of asset
Less: Purchase of asset
Finance
Sale of ordinary shares
Less: Dividends
Notes payable, paid
Cash, start
Cash, end

ACCOUNTING FOR SERVICES (contd)

PREPARING WORKSHEET
Account title
Totals
New adjusted
accounts
Totals
Net income
Net loss
Totals

3.

PERPETUAL INVENTORY - compute and record COGS at every sale

Trial Balance

Adjustments

Dr.
A

Dr.
B

Cr.
A

Cr.
B

Adjusted Trial
Balance
Dr.
Cr.
C
C

Statement of
Financial Position
Dr.
Cr.
F
G

Income Statement
Dr.
D

Cr.
E

Periodic inventory - compute COGS at end of period (NEXT PAGE)

PURCHASE (Buyer) - debit Inventory; credit Cash / Accounts Payable
Freight FOB Shipping point - buyer pays (debit Inventory, credit Cash / AP)

(E-D)
H

2.

ACCOUNTING FOR MERCHANDISING (INVENTORY)

(F-G)
(D-E)
H

(G-F)
I

Adjusting entries prepared from Adjustments columns. (Do not journalize until worksheet
is complete and financial statements are prepared. To check.)
Balances should be equal to ending balances in ledger

Purchase Returns and Allowances

Return - debit Cash / AP, credit Inventory at purchase price
Allowance (store credit) - debit Cash / AP, credit Inventory at reduction in price
Purchase discount - debit AP, credit Cash at discounted price and Inventory at discount
Purchase
Freight-In
Balance

Inventory
Purchase return
Purchase discount

CLOSING BOOKS
1.
2.
-

Journalize. Post to ledger.

(Temporary accounts: revenue, expense, net income, dividends)
Debit revenue accounts, credit total revenue in Income Summary
Credit expense accounts, debit total expense in Income Summary
Debit net income in Income Summary, credit net income in Retained Earnings,
reverse for net loss
Credit dividends account, debit total dividends in Retained Earnings
Post-closing trial balance
(Permanent accounts: asset, liability, equity)
Balances taken from ledger

SALE (Seller) - debit Cash / Accounts Receivable, credit Sales Revenue

debit COGS, credit Inventory
Freight FOB Destination - seller pays (debit Freight-Out / Delivery Expense)
Sales Returns and Allowances (contra-Revenue, normal debit balance)
Return - debit Sales Returns and Allowances, credit AR at sales price
- debit Inventory / credit COGS at fair value if damaged
Allowance - debit Sales Returns and Allowances, credit AR at reduction in price
Sales Discounts - debit Cash at discounted price and Sales Discounts at discount, credit AR at total

ACCOUNTING CYCLE
1.
2.
3.
4.
5.
6.
7.
8.
9.

Sales return

Analyze transaction
Journalize
Post to ledger
Prepare trial balance
Journalize adjustments (deferral / accrual) and post to ledger
Prepare adjusted trial balance
Prepare financial statements
Journalize closing entries and post to ledger
Prepare post-closing trial balance

Balance

ADJUSTING ENTRIES p255 - involves Inventory and COGS, unadjusted balance against physical count
CLOSING ENTRIES - Sales Revenue (debit), expense, COGS, Sales Returns and Allowances, Sales
Discounts, and Freight-Out (credit) closed to Income Summary
- Debit net income in Income Summary, credit net income in Retained Earnings,
reverse for net loss
- Credit dividends account, debit total dividends in Retained Earnings

CLASSIFIED STATEMENT OF FINANCIAL POSITION

ASSET
Intangible assets
Property, plant, and equipment
Long term investments
Current assets

EQUITY AND LIABILITIES

Equity
Non-current liabilities
Current Liabilities

Inventory
Sales
Sales discount

OBS! Freight not subject to discount

ACCOUNTING FOR MERCHANDISING (contd)

Adjusted Trial
Balance
Dr.
Cr.

Account title

INCOME STATEMENT
Sales Revenues
Sales Revenue
Less: Sales Returns and Allowances
Less: Sales Discounts
Net Sales
Less: Cost of Goods Sold
Gross Profit
Less: Operating Expenses
Income from Operations
Other income and expense
Less: Interest expense (if any)
Net Income
Other comprehensive income
Comprehensive income

Interest expense - from financing activities, closed to Income Statement

Other comprehensive income - unrealized gain / loss from revaluation of assets or liabilities
PERIODIC SYSTEM
Inventory, start
COGP
CGAS
Less: Inventory, end
COG Sold

TRIAL BALANCE

Asset
Prepaid expenses
Inventory (Dr.)
Purchases
Less: Purchase Returns and Allowances
Less: Purchase Discounts
Freight-In
Liabilities
Equity
Share capital - ordinary
Retained earnings, start
Dividends
Sales Revenue
Less: Sales Returns and Allowances (Dr.)
Less: Sales Discounts (Dr.)
Cost of Goods Sold (Dr.)
Expense
Freight-Out
Net income
Net loss
Totals

Dr.

Cr.

(D-E)
H

(G-F)
I

(E-D)
H

PURCHASE (Buyer) - debit Purchases; credit Cash / Accounts Payable

Freight FOB Shipping point - buyer pays (debit Freight-In, credit Cash / AP)
Purchase Returns and Allowances - debit Cash / AP, credit Purchase Returns and Allowances
Purchase Discounts - debit AP, credit Cash at discounted price and Purchase Discounts at discount
SALE (Seller) - debit Cash / Accounts Receivable, credit Sales Revenue
Freight FOB Destination - seller pays (debit Freight-Out / Delivery Expense)

(F-G)

COST OF GOODS SOLD

Inventory, start
Purchases
Less: Purchase Returns and Allowances
Less: Purchase Discounts
Net Purchases
Add: Freight-In
Cost of Goods Purchased
Cost of Goods Available for Sale
Less: Inventory, end
Cost of Goods Sold

Statement of
Financial Position
Dr.
Cr.

Income Statement

The gross profit rate indicates what portion of each sales dollar goes to gross profit. Compared with
rates of competitors and industry averages. Used to explain profitability.
INVENTORY
CLASS

Manufacturing: raw materials, work in process, finished goods

Merchandising: merchandising inventory

QUANTITY

Physical count
Determine ownership for goods in transit
FOB Shipping point - buyer owns goods on public carrier
FOB Destination - seller owns goods on public carrier
Consigned goods - dealer does NOT own goods

COSTING (with periodic system)

1. FIFO - not used with high inflation
Inventory, start
Purchases
CGAS
Inventory, end
Units sold

Units

Total units

Unit cost

Total cost
Total cost

Sales Returns and Allowances - debit Sales Returns and Allowances, credit AR
Sales Discounts - debit Cash at discounted price and Sales Discounts at discount, credit AR at total
(Proof of COGS)

2.

Weighted-average cost

a.
b.

To write off uncollectible account, debit ADA, credit AR-account name

In balance sheet (partial)
Current assets
Accounts receivable
Less: Allowance for doubtful accounts
Total current assets

(Proof of COGS)
3.
4.

c.
d.

NET REALIZABLE VALUE (LCNRV or LOCOM) - cost vs NRV / market value

Specific identification - indicates batch the sold goods are taken from

CHOICE OF COSTING
1.
2.
3.

Income statement effects - high inventory start, low inventory end, low net income
Balance sheet effects - at inflation, FIFO overstates inventory end, assets and equity; WAC
understates
Tax effects

Less ending inventory high COGS less net income less income taxes
CONDENSED INCOME STATEMENT (COMPARATIVE)
Sales revenue
Less: COGS
Gross profit
Less: Operating expenses
Income before income taxes
Less: Income tax expense
Net income

FIFO

WAC

To recover written off account, reverse write-off, debit Cash, credit AR-account name
To estimate allowance
i.
Percentage of sales - indicated percentage is allowance
Bad Debt Expense has direct percentage relationship to sales
ii.
Percentage of receivables - indicated percentage is required allowance
Debit Bad Debt Expense at
, credit ADA

Weakness of Direct Write-Off is that it does not match expenses with revenues. AR would not be
stated at cash realizable value in the Balance Sheet.
At year-end, adjust to record Bad Debts Expense.
FIXED ASSETS
Asset - controlled by enterprise, result of a past transaction, future benefits expected to flow into
enterprise
PLANT ASSETS - property, plant, equipment

DEPRECIATION - cost allocation, not asset valuation, done in adjusting period unless disposed

Additional cash = difference in income tax expense between FIFO and WAC

FIFO produces more meaningful inventory amount. Units are costed at most recent purchase prices.
1.

STRAIGHT-LINE

2.

UNITS-OF-ACTIVITY

FIFO more likely approximates actual physical flow of goods. Oldest goods are usually sold first to
minimize spoilage and obsolescence.
Justify sales price increase with costing method. Choose what produces highest COGS and lowest
gross profit.
ACCOUNTS RECEIVABLE
RECOGNITION - sales on account (debit AR), merchandise returns (credit AR), collection of
receivables with or without sales discount (credit AR), interest revenue from receivable (debit AR)
VALUATION (Adjusting entries)
1.
2.

Direct write-off - for credit loss, debit Bad Debt Expense, credit AR
Suitable for insignificant bad debt losses
Allowance - for uncollectible accounts, debit Bad Debt Expense, credit Allowance for
Doubtful Accounts (contra-AR account)

3.

DECLINING-BALANCE - ignores residual value, ends when book equals residual value
Year
1
2

Book value,
start
A
B

Depreciation
rate
r
r

Depreciation
expense
A(r)
B(r)

Accumulated
depreciation
A(r)
A(r) + B(r)

Book value,
end
A - A(r) = B
B - B(r) = C

FIXED ASSETS (contd)

4.

DOUBLE-DECLINING BALANCE - double the straight line rate, still ignoring residual

COMPARISON
Annual depreciation varies, total depreciation at end of useful life is equal
DB method is accelerated depreciation, largest amount of depreciation is recognized in early years
of asset life, lowest amount in later years. SL uses same depreciation each year, lower
depreciation in early years, higher in later years. UA depreciation depends on output.

Values not reflected - inventory may be valued at LOCOM, fixed assets may be undervalued in
financial report
PURCHASE of a business - increase (debit) identifiable acquired assets, credit liabilities at fair
values, credit Cash at purchase price, record difference as Goodwill
IN BALANCE SHEET
Goodwill and intangible assets
Goodwill
Trademarks and other intangible assets, net
Net goodwill and intangible assets
Property, plant and equipment
Land
Buildings
Machinery and equipment
Less: Accumulated depreciation
Net property, plant and equipment

REVISING PERIODIC DEPRECIATION

Compute new Depreciable Cost, allocate to remaining useful life
REVALUATION
Historic cost accounting - increase in asset value is not recognized in accounts
Current accounting - increase in value is recognized as increase in equity, not in income (not
distributed as dividend) but in comprehensive income as Unrealized Gain
Eliminate (debit) Accumulated Depreciation, reduce (credit) Equipment (at cost) to fair value,
record increase (credit) to Revaluation Surplus (equity account)

TAXES

DISPOSAL
DEPRECIATION

st

th

Sale on 1 - 15 of month, no depreciation for the month

th
st
Sale on 16 - 31 of month, depreciate
Remember to record Depreciation Expense for MIDYEAR DISPOSALS
1.

2.

Retirement
Eliminate (debit) Accumulated Depreciation for total depreciation up to retirement date,
reduce (credit) asset at cost, record any Gain (credit) / Loss (debit) on Disposal of Plant
Assets
Sale
Sales price
Less: Book value
Cost of asset
Less: Accumulated depreciation
Gain / loss on disposal of plant asset

Debit Cash / AR and Accumulated Depreciation, credit asset at cost, record any Gain
(credit) / Loss (debit) on Disposal of Plant Assets
INTANGIBLE ASSETS (with limited useful life)
AMORTIZATION

Debit Amortization Expense, credit intangible asset

Accounting profit, before tax

Permanent differences at year end
+ Costs, non-deductible
- Revenues, non-deductible
Change in temporary differences from 1/1 to 31/12
+ Deductible TD
- Taxable TD
Taxable profit
Tax payable
Change in deferred tax
+ Deferred tax liability (from TTD)
- Deferred tax asset (from DTD)
Less: Tax expense
Accounting profit, after tax

TAX CODE ADJUSTMENTS (DIFFERENCES)

1.
2.

Permanent difference - non-deductible costs / revenues

Temporary difference
a. Deductible TD (negative)

GOODWILL - recorded when an entire business is purchased, not amortized

b.

Taxable TD (positive)

INVESTMENTS
DEBT INVESTMENTS (BONDS)
1. Acquisition - debit Debt Investments, credit Cash
2. Interest - debit Interest Receivables, credit Interest Revenue
3. Sale
Claim revenue - debit Cash, credit Interest Receivable
Sale - debit Cash, credit Debt Investments, debit Loss / credit Gain on sale
SHARE INVESTMENTS
1. Acquisition
a. Less than 20% - debit Share Investments, credit Cash
b. 20 - 50% - debit Share Investments, credit Cash
2. Dividends
a. Less than 20% (COST METHOD) - debit Cash, credit Dividend Revenues
b. 20 - 50% (EQUITY METHOD)
Recognize - debit Share Investments, credit Revenue from Share Investments
Claim - debit Cash, credit Share Investments
3. Sale
a. Less than 20% - debit Cash, credit Share Investments, debit Loss / credit Gain
b. 20 - 50% - debit Cash, credit Share Investments, debit Loss / credit Gain
VALUING AND REPORTING (Adjusting entries and Financial Statement)
BALANCE SHEET
Debt - Current Assets > Short-term investments, at fair value
Share - Investments > Investments in shares of (percent), at fair value (<20%)/ equity (20-50%)
1. Trading securities (Debt and Share) - at fair value

2.

3.

Debit Fair Value AdjustmentTrading, credit Unrealized GainIncome (reverse for Loss)
Gain / Loss as Other income and expense in INCOME STATEMENT
Non-trading securities (Share) - at fair value
Debit Fair Value AdjustmentNon-trading, credit Unrealized GainEquity (reverse Loss)
Add: Unrealized Gain / Less: Loss on Non-trading Securities in Equity in BALANCE SHEET
Held-for-collection (Debt) - at amortized cost

CASH FLOW STATEMENT

OPERATING ACTIVITY - reflected in Income Statement
CASH IN
Sale of goods or services
Interest received
Dividends received

CASH OUT
To suppliers for inventory
Employees for services
Government for taxes
Lenders for interest
Other for expenses

INVESTING ACTIVITY - change in Investments and Non-current Assets in Balance Sheet

CASH IN
Sale of property, plant and equipment
Sale of investments in debt or equity securities of others
Collection of principal on loans to others

CASH OUT
Purchase property, plant and equipment
Purchase investments in debt or equity securities of others
Loans to others

FINANCING ACTIVITY - change in Non-current Liabilities and Equity in Balance Sheet

CASH IN
Sale of ordinary shares
Issuance of long-term debt

CASH OUT
Dividends to shareholders
Redeem long-term debt or reacquire ordinary shares

CASH
Cash and Cash Equivalents, start
Operations
Investments
Financing
Cash and Cash Equivalents, end

1.

2.
3.

Identify change in Cash with provided Balance Sheet

a. Increase in assets - cash out
Decrease - cash in
b. Increase in Liability / Equity - cash in
Decrease - cash out
Categorize change as OA / IA / FA
Prepare Cash Flow Statement in chosen method

DIRECT METHOD
Cash in from operating activities
Less: Cash out OA
Cash in from investing activities
Less: Cash out IA
Cash in from financing activities
Less: Cash out FA
Net increase / decrease in cash
Add: Cash, start
Cash, end

INDIRECT METHOD
BALANCE SHEET
Assets
Cash and Cash Equivalents
Liabilities and Equity

CHANGE IN CASH

CASH FLOW STATEMENT (contd)

OPERATIONS
Net Income
Add: Non-cash expenses
Add: Loss from IA / FA
Add: Decrease in Current Assets
Add: Increase in Current Liability
Less: Gain from IA / FA
Less: Increase in Currents Assets
Less: Decrease in Current Liability
Cash OA

INVESTMENTS
Fixed assets, start
Add: Purchase of FA
Less: Depreciation
Less: Sale of FA
Less: Writing-down value
Fixed assets, end
Add: Short term investments
Less: Purchase of PPE
Cash IA

RATIO (inter-, intra-company, industry average) - analyze at three levels

FINANCING
Increase in long term debt
Less: Dividends paid

LIQUIDITY - short term ability of company to pay maturing obligations and meet unexpected needs for cash

- short term debt paying ability

- currency unit of current assets for every 1 currency unit of current liabilities
- does not take into account composition of current assets

Cash FA

ANALYSIS
1. Is Cash OA positive?
If company does not make money on OA, check or do not trust
Company life cycle:
2. Compare Cash OA with dividends and net capital expenditure
Mature company is less likely to finance cash dividends and capital expenditure out of
Cash OA
If company has to borrow money for capital, check or do not invest
3. Determine effect of Free Cash Flow on investments and finances
What does company do with cash flow? Repay debt? Expand? Pay owners?
FINANCIAL STATEMENT ANALYSIS
HORIZONTAL (intra-company)
- involves Balance Sheet, Income Statement, Retained Earnings Statement
- percentage periodic change, increase / decrease
- explain what the company must have done to make the changes

- immediate short term liquidity

- excluded: inventory may not be readily saleable, prepaid expenses may not be transferable

- liquidity of accounts receivable

- how quickly company can convert accounts receivable to cash
- average number of times company collects receivables during the period

- effectiveness of company credit and collection policies

- collection period should not greatly exceed credit term period

- liquidity of inventory
- average number of times inventory is sold during period
- faster inventory turnover, lass cash tied up with inventory, less chance of inventory obsolescence

- average selling time

PROFITABILTY - income or operating success of company, ability to obtain debt and equity financing, liquidity position,
ability to grow

- percentage net income generated by each currency unit of sales

- high volume (INV turnover), low profit margin; vice versa

VERTICAL (inter-, intra-company)

- item percentage of base amount
- eliminates difference in size for intercompany comparison

BALANCE SHEET
- asset items based on Total Assets, equity and liability items based on Total Equity and Liabilities
- shows relative size of each category, percentage change in each item
INCOME STATEMENT
- each item based on Net Sales, percentage size of item

- how efficiently assets are used to generate sales

- currency unit of sales produced by 1 currency unit invested in assets
- ratios vary considerably among industries

- overall profitability of assets

- profitability of owners investment

- currency unit of net income company earned for each 1 currency unit invested by owners

- deduct preference dividends for income available to ordinary shareholders

- deduct par value of preference shares from total equity for amount of ordinary shareholder equity to use
- LEVERAGING
= at gain, company borrowed money at lower rate of interest than it is able to earn by using this borrowed money
= use money supplied by non-owners to increase return to owners
- profitability of trading on the equity
- positive leveraging, company earns more on borrowed funds than it has to pay in the form of interest
- negative leveraging, company earns less on borrowed funds than it has to pay in the form of interest

- net income earned on each ordinary share, amount of net income applicable to each share
- assuming no change in number of outstanding shares
- (intra-company only) wide variation in number of outstanding shares among companies
- deduct preference dividends for income available to ordinary shareholders

- ratio of the market price per share to earnings per share

- investor assessment of companys future earnings
- share is sold for x times the amount that company earned on each share

- percentage of earnings distributed in the form of cash dividends

- high growth rates, low payout ratio, reinvest most of income into business
SOLVENCY - ability of company to survive over long period of time, ability to pay interest as it comes due, ability to repay
face value of debt at maturity

- percentage of total assets provided by creditors

- companys degree of leverage
- ability to withstand losses without impairing the interests of creditors
- higher percentage, greater risk that company is unable to meet maturing obligations
- lower ratio, more equity buffer available to creditors

- ability to meet interest payments as they come due

- use income before income tax and interest expense for amount available to cover interest

EARNING POWER - normal level of income to be obtained in the future

- differs from actual net income by the amount of irregular revenues, expenses, gains, and losses
- helps derive an estimate of future earnings without noise from irregular items
IRREGULAR ITEMS - separately identified in Income Statement
Discontinued operations - disposal of significant component of business
Income before income taxes
Less: Income tax expense
Income from continuing operations

Discontinued operations
+ Income from operations, Gain from disposal
- Loss from operations, Loss from disposal
Net income

CHANGE IN ACCOUNTING PRINCIPLE

- principle used in current year differs from one used in preceding year
- accounting rules permit change if justified
- most changes are reported retroactively
- e.g. change in inventory costing method (FIFO to average-cost)
COMPREHENSIVE INCOME
- certain items bypass income and are reported directly in equity.
= unrealized gains / losses on non-trading securities are reported directly in Balance Sheet as
adjustments to equity
= companies that employ revaluation accounting do not include the revaluation surplus in
income, it is also an adjustment to equity
- comprehensive income includes all changes in equity during a period except those resulting from
investments by shareholders and distributions to shareholders
Why are gains and losses on non-trading securities excluded from net income?
Disclosing them separately reduces volatility of net income due to fluctuations in fair value, yet
informs financial statement user of gain / loss that would be incurred if securities were sold at
fair value
QUALITY OF EARNINGS
- high quality of earnings provides full and transparent information that will not confuse or
mislead users of the financial statements
FACTORS AFFECTING QUALITY OF EARNINGS
1. Alternative accounting methods - variations among companies in application of IFRS may
hamper comparability and reduce quality of earnings; differences can be detected by reading
the reports notes, but adjusting financial data to compensate for different methods is often
difficult, if not impossible
2. Pro forma income - excludes items that company thinks are unusual or nonrecurring; some
companies have abused flexibility that pro forma numbers allow
3. Improper recognition - some managers have felt pressure to continually increase earnings
and have manipulated earnings numbers to meet expectations
- improper recognition of revenue (channel stuffing)
- improper capitalization of operating expenses (WorldCom - USA)
- failure to report all liabilities (Enron - USA)